Monetary Authority Changes

The monetary authority changes interest rates through open-market operations. If it wants to boost aggregate spending, it does so by cutting interest rates, and it cuts interest rates by purchasing government bonds with money. An interest rate cut is equivalent to an increase in the supply of money, so the monetary transmission mechanism also teaches us that an increase in the supply of money leads to an increase in aggregate spending. [6] The monetary transmission mechanism is useful when we want to understand the short-run effects of monetary policy. When studying the long run, it is easier to work with the quantity equation and to think about monetary policy in terms of the supply of money rather than interest rates. Finally, a reminder: in the short run, the neutrality of money does not hold. This is because in the short run we assume stickiness of nominal wages and/or prices. In this case, changes in the nominal money supply will lead to changes in the real money supply. With sticky wages and/or prices, the classical dichotomy is broken. Long-Run Inflation We now use the quantity equation to provide us with a theory of long-run inflation. To do so, we use the rules of growth rates. One of these rules is as follows: if you have two variables, x and y, then the growth rate of the product (x × y) is the sum of the growth rate of x and the growth rate of y. We can apply this to the quantity equation: money supply × velocity of money = price level × real GDP. The left side of this equation is the product of two variables, the money supply and the velocity of money. The right side is likewise the product of two variables. So we obtain growth rate of the money supply + growth rate of the velocity of money= inflation rate + growth rate of output. We have used the fact that the growth rate of the price level is, by definition, the inflation rate. Toolkit: Section 16.11 “Growth Rates” You can review the rules of growth rates in the toolkit. We continue to assume that the velocity of money is a constant. [7] Saying that the velocity of money is constant is the same as saying that its growth rate is zero.